How to determine the appropriate price?
Pricing Decision 1. Cost of production The profit obtained from the total sales should cover the cost of production so that the company will not run out of capital and cash flow. The cost of production is divided into 2 types, which are variable costs and fixed costs. Variable cost varies according to the number of units produced, such as the material cost. While fixed cost is not affected by how many units that will be produced but this cost is still substantial, such as rents, advertising, and promotion costs. 2. Competitive conditions in the market If the company is the only standing firm for a product, then it will be likely that this company is a monopolist. But if there are a lot of competitors, the company that has the highest market share will tend to be the price setter rather than the others. 3. Competitors’ prices The price of the same product generally shows only small differences with the other competitors’ products (especially, they will follow the price set by the dominant firm). Unless they can show some outstanding value of the product. 4. Business and marketing objectives If a business aims to maximize the profit, then it will be likely that the business set the price high. While for a business that focusing on growth, they tend to maximize sales to secure the greatest possible market share. Maximize sales can be obtained by setting the price that is preferable by the consumers and is suitable with the quality of the products, not trying to maximize the outcome profit. 5. Price elasticity of demand (PED) It has been already discussed above. 6. Whether it is a new or an existing product If it is a new product, the pricing decision will use ‘skimming’ or ‘penetration’ method, which will be discussed further later on. Pricing methods Cost-based pricing Cost-based pricing means that a business or firm will set their products’ price based on the cost of production and add an amount on the top as their profit. There are several different methods of cost-based pricing, which are: 1. Mark-up pricing Mark-up pricing à adding a fixed mark-up for profit to the unit price of a product. This method is often used by retailers by adding percentage mark-up to the cost of production so that they will get a fixed profit from product sales. Example: · Total cost of production à $40 · 50% mark-up on cost à $20 · Selling price à $60 2. Target pricing Target pricing ''à setting a price that will give a required rate of return at a certain level of output/sales. If a company produces 1000 units with cost $5000 and they expected a return of 20%, then it will set its price by working out its total cost and expected return and then dividing the amount by output. · Total output cost of 1000 units à $5000 · Required return of 20% on sales à $1000 · Total revenue needed à $6000 · Price per unit 6000/1000 à $6 '''3. Full-cost (or absorption-cost) pricing' Full-cost (or absorption-cost) pricing ''à setting a price by calculating a unit cost for the product (allocated fixed and variable costs) and then adding a fixed profit margin. This method is actually almost the same with mark-up pricing but adds the value of fixed price into the calculation. For example, a company’s producing 5000 units per year with each unit variable cost $6 and fixed cost (promotion, building rent) $10000. · Total cost (variable & fixed costs)à (5000x ($6)) + $10000 = $40000 · Average unit cost à $40000/5000 = $8 So at least the business should sell the product $8 per unit to cover the variable and fixed cost. If the firm adds 200% profit margin then the total selling price becomes $24. '''4. Contribution-cost (or marginal-cost) pricing' Contribution-cost (or marginal-cost) pricing ''à setting prices based on the variable costs of making a product in order to make a contribution towards fixed costs and profit. This case is best explained using an example. If a firm sell each unit of the product with price $5 (based on the variable cost only) and the total fixed cost is $10000, and set a contribution of $1 per unit, then the fixed cost will be covered after the firm can sell 10000 units. The sales after 10000 units will give the firm what is called as profit. So let’s say if the firm can sell 30000 units, then the firm gain $20000 profits. '''5. Competition-based pricing' Competition-based pricing ''à a firm will base its price upon the price set by its competitors. There are several different scenarios in which this approach can be used: - The price will be set based on the dominant firm, which usually characterized by having the highest market share in the market. - Businesses with the same size in the market will tend to have similar price to avoid a price war. - Destroyer pricing exists when they deliberately wants to undercut the competitors by setting very low prices so that they can force them out of the market. - Setting price based on the market condition. This is usually called as consumer-based pricing. However, the study of market is usually more detailed than just looking at the consumers’ responses. Therefore there are two different pricing strategies come under the market-oriented pricing: 1. Perceived-value pricing (customer-value pricing) This strategy is used for products that have inelastic demand. Not only for staple goods, but it can also be applied for normal goods that reflect its value. For example, Rolex watches, the higher the perceived value, the higher the price that can be set. 2. Price discrimination This strategy is applied in the market when it is possible to charge different price for different groups of the same product. The example has already been discussed above, on the ‘applications of price elasticity of demand’ number 2. '''New product pricing strategies' 1. Penetration pricing Penetration pricing ''à setting a relatively low price often supported by strong promotion in order to achieve a high volume of sales. This kind of case is sometimes referred as a conflict in corporate objective, growth vs. profit. Penetration pricing is a strategy that focuses more in the growth of a business by allocating more money for promotion or to maximize the sales so that it can secure the greatest possible market share. '''2. Market skimming' Market skimming ''à setting a high price for a new product when a firm has a unique or highly differentiated product with low price elasticity of demand. This strategy aims to maximize short-term profit before other competitors enter the markets and to project an exclusive image for the product. Because once competitors have entered the market, the firm will gradually lower the price so that consumers are not switching to the competing brands that have lower price. '''Pricing decisions – some additional issues' Different types of markets The easier the firms to enter a market, the more competitive the market will be. Therefore it is quite common to see these firms use competition-based pricing in order to survive. The most extreme form of competition is called as perfect competition. There are 4 conditions of perfect competition, which are: - Perfect consumer knowledge about prices and products. - Firms’ products are of equal quality or homogeneous. - There is freedom of entry into and exit from the industry. - There are many consumers and producers, and none of the latter is big enough to influence prices on its own. In this kind of condition, the firms will be the price takers and all the firms should set the same price with the others. Because if the price is slightly different, then the customers will directly change to the competing products thus this company will not able to sell anything. This is especially true for agricultural sector where a world market price has been set. Besides perfect competition, there is another issue of monopoly. In this case, there is a dominant firm that has the greatest possible market share thus this firm will become the price setter. For examples are water-supply company, electricity generator company, etc. Sometimes, this kind of monopoly is hard to get rid off because it also requires a lot of capital to enter the market competition of those businesses. Another issue in pricing decision is oligopoly. Oligopoly is the type of competition in which there are only a few firms that can dominate the market. There are several ways in which oligopoly industries compete with one another, which are: - Price wars to gain market share This method can be very dangerous to small businesses as well as damaging the profit of the company itself. Because as the dominant firms are trying to lower their price to gain more market share, the small businesses should also lower their price following the dominant ones. Therefore this can lead to bankruptcy because of the poor cash flow. - Non-price competition As explained above, because price war is too dangerous, therefore a non-price competition is preferable by businesses in order to promote their products and to gain more consumers’ loyalty. This can be done through advertising and promotional campaign to establish brand identity and dominance. - Collusion As both of the methods above is costly and can reduce profit, therefore oligopolistic industry will find it easier to collude as in the formation of cartel. But this practice is often illegal. Loss leaders ' '''This tactic is commonly used by retailers. This tactic works by lowering the price of one product (sometimes the price can be below the variable cost) in order to encourage the consumers to buy the other products. The expectation is that the sales of the other products can cover the loss in price from the sacrificed product. For example are complementary goods. '''Psychological pricing' ' '''This tactic has two aspects. The first one is to set price just below the key price level, such as $99 rather than $101. Even though it only shows slightly difference, but consumers will still consider the price as low because the value is under $100. Second, the price that is set could be much higher than the variable cost in order to create the status and exclusive image that the firm is trying to portray. Because sometimes consumers believed that products with high price have a better quality rather than the ones with low price. For example, perfume A and B is created from the same materials with the same quality that only cost $50. However, perfume A’s selling price is $100 while perfume B is $50. Consumers that don’t know if the perfume is actually the same will tend to buy perfume A because they believed that perfume A has higher price because of high quality. This kind of perspective has already shape how society thinks. Therefore psychological pricing is essential. '''Pricing decisions – an evaluation' - It would be incorrect if a business uses the same pricing method for different products, considering that different products mean that it also has different market condition. - Market research is important to ensure the consumers’ reactions towards different price levels. - Low price doesn’t always mean more demands. This is happen because people also see whether the products have good value or not. Therefore the integration of 4Ps (product, price, promotion, place) should be well placed. - A good value of products is not only assessed by the price. In this modern world, the brand image and the lifestyle offered by the goods are increasingly important as the consumers’ incomes are rising.